The Dry Season

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Like many talented entrepreneurs, Henry White is a serial founder. Still only 41, White has already been involved in four start-ups. The first was profitably sold. The second was melded into a roll-up. The third grew to $100 million in annual sales before White moved on.

The fourth sounded as promising as any of these. Salisbury, Massachusetts-based PlumRiver Technology Inc. produced online software and services that consumer-goods manufacturers could harness to drive sales to retailers of footwear, sporting goods, and apparel.

To support it through the three years after its 1999 founding, PlumRiver received $7 million in two rounds of financing and a succession of short-term drafts, from lead financier Venture Investment Management Co. LLC (Vimac), a Boston-based venture-capital firm, and first-round investor Richemont International. In mid-2002, White had what seemed a likely commercial breakthrough — a deal with a prominent manufacturer that promised to prime cash flow. Nonetheless, that same week, driven by the sour economy, Vimac lopped PlumRiver from its portfolio. White is now a consultant — the title of choice among similarly bright but out-of-work entrepreneurs. “Up to early 2002, [Vimac was] in the mode of keeping companies alive,” he says wistfully.

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You could say PlumRiver fell victim to a poor choice of market. The three vertical segments it chose to serve — shoes, outdoor apparel, and sporting goods — are notably conservative when it comes to adopting new technology. But, just as surely, it is also the victim of a deteriorating economy and the post-dot-com dwindling of VC returns, one of many promising early-stage undertakings crippled by a withdrawal of capital sponsorship.

The Shrinking Venture Capital Pool

As annual returns slipped perilously in 2002, many VC firms pulled in their horns. According to a PricewaterhouseCoopers-Venture Economics-NVCA MoneyTree survey, between 1999 and 2002, expansion-stage investment by the nation’s 750-odd VC firms shrank some 60 percent — from $30.8 billion to $13.3 billion.

Apart from yanking the financing from the PlumRivers of the world, some VCs gave up the ghost entirely, while others variously reduced staff, slashed the size of their working funds, cleansed their portfolio companies of cash drainers, and revamped their investment philosophies away from early-stage investments and toward putatively safer later-stage ones. Among the departed, ironically, was Barksdale Group, led by Jim Barksdale, former CEO of prominently venture-backed Netscape; the group shut down after only four years. Charles River Ventures sliced its latest fund by a massive 63 percent, from $1.2 billion to $450 million.

Another practice undertaken by VC firms to insulate themselves from harsh economic realities has been to place laggard portfolio companies into hibernation by doling out capital in life-supporting trickles. Investors were placing their portfolio companies “in sustained-growth mode,” summed up VentureOne head of research John Gabbert, “raising enough to continue operations, but not gearing up for an immediate IPO or acquisition.”

Such was the case with Cambridge, Massachusetts-based emerging-growth-specialist Zero Stage Capital and its Web property, FurnitureFan. An online guide to branded furniture carried in retail stores, FurnitureFan received its initial round in 1999, and its third — and so far last — in March 2001. The latter, some $4.1 million, was intended to carry the company to the end of that year, by which time it was expected to reach self-sustaining profitability. Instead, FurnitureFan passed all of 2002 and at least some of 2003 essentially going nowhere.

A typical tale of the times, FurnitureFan’s adventure started in 2000, when Zero Stage hired Mitchell Russo, an experienced, 48-year-old entrepreneur, to take over as CEO and rework the company’s failing business plan. Russo proceeded to design so resourceful an approach to furniture promotion and sales over the Internet that Zero Stage contributed its third round of capital despite the concurrent collapse of the dot-coms. Russo spent the money building credibility within his market and developing a revenue base.

But the company fell short of positive cash flow and was unable to secure the follow-up financing that would have constituted its fourth, or Series C, round. With valuations rocketing south, Zero Stage was stuck with its not-there-yet charge. Like PlumRiver, FurnitureFan had fallen prey to the bad economy and a niche — the furniture trade — that is resistant to change.

With revenue arrested at about $1 million, Zero Stage directed Russo to prune his management team and reduce expenses, thus forcing the operation into dormancy. “We weren’t given the resources to move forward. We were held back from expanding,” Russo says — but not ungratefully. “At least we have cooperative investors who understand what we are doing, and support it. If they can just keep us alive during this period of terrible business, when business does pick up,” he anticipates, “we’ll emerge as being quite valuable.”

But how long will his financier keep slipping Russo walking-around money? “As long as he keeps creating value, and as long as our funds have the capital, we’ll fill in the gap between his revenues and his cost,” Zero Stage managing director Bic Stevens pledges. “We told all our companies, even those with lots of cash, ‘Don’t plan on getting any outside new financing, cut your burn rate, do things smarter.'”

Russo is philosophical about his situation.” Many [VCs] went back and reexamined their original charters to see if they still made sense,” he says, “and they determined that the risk-reward map had changed. They can’t make a new investment unless they’re willing to take it right through to a public offering or the sale of the company. Since there’s no way for them to stage a liquidity event,” Russo says, “they have to keep feeding [their companies] money without returns. Zero Stage Capital — their name tells the story. They never expected to have to go beyond the seed stage of a company’s life.”

The Corrections

Times change, and so do expectations. “During the bubble, a college kid could start a company on the back of an envelope,” says Stephen Van Beaver, a general partner at Boston-based Pilot House Ventures. Now, he says, the climate for start-ups “is the worst it’s ever been. Industry returns are way off, and we’re still weeding out excess inventory.”

Investors have seen the folly of their ways, and start-ups are suffering as the VC firms try to correct their past mistakes. And while seed and start-up terms — if you can find them — are relatively unchanged, expansion-round deals have become far less generous. Venture capitalists are “investing at much later stages, and they’re investing at very low valuations, and the terms are severe,” says Rob Ryan, co-founder and president of Entrepreneur America, which offers mentoring services to start-ups (see “Hope Springs Eternal,” at the end of this article). ‘They put less money in and take a much bigger portion of the company out.”

What’s more, expansion-round money won’t be forthcoming unless a start-up can demonstrate that it has “real customers, and that the product works as specified,” says Van Beaver. “You can’t have just one customer who’s bought just one product. You have to have numerous customers and many products, and you have to show real revenue.”

In short, the VC world has become more risk-averse than ever. “A start-up has to prove that it has a billion-dollar application,” complains Ryan, who himself has founded three multibillion-dollar enterprises, most spectacularly the computer-networking company Ascend Communications. “And I know of no company that you can prove from the start is a billion-dollar opportunity. None of them come packaged with little signs on them.”

And in the Future?

The collective total of failed and underfed companies may hurt the economy a few years down the line, when the customary vitality of emerging small-caps will be a sorely missed component of the economy. “If VCs have started cutting back on their expenses and focusing on the companies they have commitments to,” notes John Hatsopoulos, ex-CFO of medical-instrument maker Thermo Electron Corp. and now a partner at GlenRose Capital LLC in Boston, “that leaves the bulk of small companies without a future. Vigorous company creation is the advantage the U.S. has always had over Europe, and it’s not happening this time around.”

An even more pessimistic view is held by a consultant who often serves as CFO to start-ups, guiding them to later stages. Speaking on condition of anonymity, he surveys the landscape thus: “VCs I know are loaded up with companies that are not going to make it. In normal times, they would have closed the ones that are in the shape these are in. But if they close them, it would look so bad that the appearance of VC failure would be overpowering. So they’re giving them just the minimum to survive. The point of this is not the business of investment, but the management of appearances.”

In normal times, explains the consultant, VCs always close down companies, “but they always have winners to offset them. The difference now is that the winners aren’t there within a given fund. In some cases, everything a fund invested in at the top of the market in 1999 or 2000 is questionable-to-lousy now. These firms — and many private investors — are on the verge of taking huge losses. They just don’t want anyone to know.”

As illustration that the swift decline in company valuations is crippling expansion, Hatsopoulos tells of Ovation Products, a start-up in Nashua, New Hampshire, which developed a distillation process that recovers waste from sinks and toilets and, at about 0.2 cents a gallon, reconstitutes the effluent into pure distilled water. Based on its promising technology and seemingly limitless market, in 1999 the company raised $1.8 million from private investors at a $15 million valuation. After two years, when Ovation went for an expansion round, essentially the same team and technology were valued at only about a third of the original amount.

“It’s unbelievable what’s happening,” says Hatsopoulos. “Terms are getting tougher, but even with the tough terms, you can’t get any money. And the ones that do get funded for a bit of money end up losing their equity, because obviously if you raise money at a very low valuation, ownership by the founders goes down dramatically.”

Take the Money and Run

The dilemma for an aspiring start-up is this: If financing terms seem onerous, should a company accept them anyway? In a heartbeat, advises PlumRiver’s White. “If an investor is passing around cookies, take them,” he urges. “Because you’re trying to do the best for the company and the stockholders, you tend to get caught up too much in the dictates of a deal. The reality of this marketplace is you’re fortunate to have a VC at all.”

And if the next batch of cookies is slow in coming? At Zero Stage, managing director Stevens is determined to keep FurnitureFan on a pay-as-it-goes basis. “What we’re saying is, don’t depend on the rest of the venture-capital community; let’s go with what we’ve got,” says Stevens. “Let’s husband our resources, and make sure FurnitureFan doesn’t have to raise money again.”

For all the capital retrenchment and economic gloom, seasoned company-builders like Rob Ryan aren’t discouraged. “The VCs aren’t doing as much as three or four years ago, but they’re still doing deals. The deals are going to cost you more. But if they give you a chance to use their capital,” Ryan advises, “go for it, no matter what the terms are. Then build something big.”

It still can be done. For all their troubles in the new millennium — decimated valuations, a precipitous falloff in IPOs, a broad slowdown in M&A activity, global recessionary and deflationary trends, stock-market disasters — VC firms nonetheless poured $17.43 billion into private entrepreneurial companies in 2002 (according to a year-end summary by VentureOne/Ernst & Young). Which happens to be $2 billion more than in 1998. And everyone knows what happened in the two years after that.

Robert A. Mamis is a freelance writer based in Hull, Massachusetts.

Hope Springs Eternal

To an anxious entrepreneur, tightness of investment capital needn’t matter in the end, says Rob Ryan. And he ought to know. Ryan has, from scratch, grown three multibillion-dollar companies, the most prominent being Ascend Communications, founded in 1989 and sold to Lucent Technologies in 1999 for $24 billion — the largest sum ever for a technology company. Since then, he has founded and now runs Entrepreneur America, a mentoring facility for start-ups, in which he teaches his protégés how to raise money, among other basics. Ryan holds intense classes at his ranch in Montana, then sends students back home to apply what they have learned to reconstructing their business models. If that painful process goes well, he usually invests in the companies.

But truth be told, he’d rather his charges worked in nonfinanced bootstrapping mode. “When you start with $5,000,” Ryan figures, “either you’re going to fail immediately or you become a real entrepreneur. At least you know the basics of managing money. You have to generate customers, and customers have to pay you, and you’re going to have to spend only what you have. Frankly, most start-ups don’t consider that they’re spending someone else’s money. You don’t have that trouble with bootstrapped companies. They have to earn each penny they’re spending.”

In growing Ascend, Ryan raised capital from some of the country’s premium VCs, among them Kleiner, Perkins, Caufield & Byers; Greylock; and NEA. However, he recalls, “the terms I got weren’t that great. I raised $2 million for 50 percent of the company on the first round. And by the time it went public five years later, the venture people owned about 75 percent of the company. The employees and I owned the rest. On the one hand, they took a lot of the company. On the other, they gave me the opportunity to get a company built.” When employees at Ascend became restless as the dilutive tendency revealed itself through successive rounds, Ryan liked to remind them: “If you own 1 percent of Montana, you own a lot of land. If you own 10 percent of New Jersey, that’s much less.” —R.A.M.